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Sunday, March 27, 2011

The Unintelligent Investor’s Definition of the Week: Short selling.

Oxford Dictionary’s definition: Sell stock or other securities or commodities which one does not own at the time, in the hope of buying at a lower price before the delivery time

The Unintelligent Investor’s explanation:

To short sell or short a stock, you are selling a stock that you do not own hoping that it will drop in value in the future so that you can buy it at a lower price to make a profit. How do you sell a stock that you don’t own? The broker will lend them to you.

The share markets can move in 3 ways, upwards, downwards, or sideways. To make money when the stock is going upwards, you take a long position (buy low, then sell high). To make money when the stock is moving downwards, you take a short position (sell high, buy back low) and there are various ways to make money when it is moving sideways.

If you do not yet understand what it means, I hope this example will help.

Let’s say you own a fruit store, because of natural disasters, the prices of bananas sky rockets. There is this customer that loves his bananas so and really wants to buy but you don’t have bananas to sell. Now you don’t want to miss this opportunity to sell bananas to this guy at a high price because you know that once supply is back to normal, the prices will drop again.

So you call your fellow fruit seller whose shop isn’t doing as well as yours, say the Unintelligent Investor. He agrees to lend you the bananas as long as you return them within 3 months and pay a small fee (brokerage). You sell the bananas to this guy at a high price, wait a few months and when the supply goes back to normal, the prices drop and you buy the bananas from your supplier and return whatever you borrowed back to the Unintelligent Investor. Laughing to the bank as you do it.

Now let’s apply that to the share markets. Say a company’s share price goes up very high but you think that the prices will drop because of factors that you have identified. So you decide to short sell 1000 shares at 10 dollars each. That will give you 10 000 dollars in cash. Your predictions were correct and the prices dropped to 3 dollars. So you buy back 1000 shares from the market at 3 dollars each, paying 3000 dollars. Hence, you have just made a profit of 7000 dollars from a company that is falling in value. The ideal situation will be if the company went bankrupt, because you then do not have to pay anything to buy the shares back and you would have made the full 10 000 dollars

However, if you were wrong and the price continue to go up, say to 15 dollars, you’ll be forced to buy back 1000 shares at 15 dollars which will cost you 15 000. Hence, your loss will be 5 000 dollars.

Below are 2 graphs that show you the different pay off diagram of going long and going short

Remember that by no means am I encouraging you guys to start short selling. Shorting a stock brings different sets of risk, for example, your gains are limited because the lowest the stock can go to is 0 where as your losses are potentially infinite because there is no telling how high a stock can go. Before we consider short selling, we have much to learn.

This segment is purely to explain certain investment jargons so that when people talk about it or if we read about it, we will know what it is about.

Thanks for reading. I hope my explanation was helpful, drop me a comment or email if it was, or if I didn’t explain it well enough, definitely let me know so that I can explain it better. Like me on facebook or follow me on twitter if you like what you’ve read so far. Thanks!